In the context of taxation of fixed income mutual funds, it is known that tax efficiency is generated over a holding period of three years. The investment in the growth option of the fund becomes eligible for taxation as long term capital gains (LTCG). The rate of taxation for LTCG is 20%, plus surcharge and cess as applicable, with the benefit of indexation. What needs to be refreshed is that while the principle of LTCG taxation remains same as earlier, there is a new series of cost inflation index (CII) numbers which needs to be taken into account.
The erstwhile series of CII numbers started from 1981-82, which was set at 100 and the numbers for all subsequent years reflect the moves in consumer price inflation. The revised series of CII numbers start from 2001-02 which has been set at 100. The new series of CII numbers is applicable from assessment year 2018-19, i.e., financial year 2017-18. Hence it is useful for investors to be aware of the revised set of numbers, though there is no significant change in the basis of taxation. Now let us look at a couple of illustrations to understand how indexation works.
You invested in a fixed maturity plan (FMP) on March 26, 2013. It matured on September 4, 2016. Starting NAV was Rs 10, and terminal NAV was Rs 12.5. What is the incidence of LTCG tax? Your year of purchase was 2012-13, when the CII was 200. Year of sale/redemption was 2016-17, when the CII was 264. Hence the purchase cost gets ‘indexed’ to 264/200 X Rs 10 = Rs 13.2. Since the indexed cost is higher than the redemption NAV, there is no tax incidence. In fact, there is a notional loss, which can be adjusted against other long term gains.
You invested in an FMP on April 17, 2013. It matured on September 4, 2016. Starting NAV was Rs 10, and terminal NAV was Rs 12.5. What is the incidence of LTCG tax?
Your year of purchase was 2013-14, when the CII was 220. Year of sale/redemption was 2016-17, when the CII was 264. Hence the purchase cost gets ‘indexed’ to 264/220 X Rs 10 = Rs 12. The indexed long term capital gain is Rs 12.5 minus Rs 12 = Rs 0.5. Let’s take the LTCG tax rate at 20%, ignoring surcharge and cess for simplicity. The incidence of LTCG tax comes to Rs 0.5 X 20% = Rs 0.1 and the net of tax realization is Rs 12.5 minus Rs 0.1 = Rs 12.4, without considering surcharge and cess.
The inflation benefit given to investors in the new series of CII numbers is similar to the earlier series.
Tax efficiency of LTCG over STCG
Assuming you are in the highest tax bracket, i.e., 30% plus surcharge and cess, LTCG is much better as the tax rate is lower and you get the benefit of indexation. Even if you are in the 20% tax bracket, LTCG is better than STCG by virtue of indexation. The investor being in 5% or lower tax bracket, i.e., income less than Rs 5 lakh per year is an exception.